November Credit Update

Monthly Commentary

November was another challenging month for credit as we saw the same themes continue to weigh on spreads – macro concerns, late cycle fears, deteriorating liquidity conditions and rising idiosyncratic risks. After getting lulled into complacency by low volatility and consecutive years of spread tightening, the market has experienced a meaningful correction since touching the post crisis tights in February. The credit index OAS was 17 basis points wider in November, posting the worst excess return (-1.07%) in almost two years while the Ytd total return of -3.56% is the worst since 1994. While the nominal OAS of +129 bps over Treasuries is still tight of the 20 year historical mean (of +150), spreads have widened out nearly 30 bps in just two months. The shift in investor sentiment, coupled with deteriorating year-end liquidity, has exacerbated the moves as dealers are reluctant to add risk into year end. The resurgence of debt-funded M&A activity at a time when overseas buying has tapered and inflows into ETFs and mutual funds have decelerated has tilted the supply/demand imbalance. There is also a renewed focus on credit fundamentals – including issuer specific credit metrics and ratings sustainability. As a result, lower rated, higher beta, higher levered and/or more cyclical credits underperformed. The spread between BBB and single A rated securities widened 12 bps
in November to 68 bps, driven by commodity and auto sector underperformance.

IG Credit Index Yields and Spreads:

Credit index OAS of +129 is 17 bps wider MTD, 40 bps wider YTD

Source: Bloomberg Barclays

YTD Total Returns For Various Fixed Income Classes

Source: Bloomberg Barclays

Annual Excess and Total Returns:

YTD Total Return of -3.56% is the worst in over two decades.
YTD excess return of -1.84% is the worst since 2011.

Source: Bloomberg Barclays

On the Demand Side, Fund Flows Have Decelerated:

YTD cumulative IG fund flows for daily reporting funds.

Source: Bloomberg Barclays

The BBB Portion of the IG Credit Universe:

Grown considerably over the cycle and is now close to 50%.

Source: Bloomberg Barclays

Index Performance: The credit index OAS of +129 bps over Treasuries was 17 bps wider on the month. Lower Treasury yields were
not enough to offset wider spreads, resulting in both negative total returns (-.07%) and excess returns (-1.84%) for the month of
November. Spread performance was weak across the board with BBBs underperforming as the theme of decompression continued.
Worst performing sectors were either cyclical (autos, energy, chemicals) or those with idiosyncratic issues (tobacco and diversified
manufacturing/GE). The number of idiosyncratic stories has grown, including GE, which has experienced significant spread widening
since losing its single A ratings – with spreads out 109 bps in November and 200 bps wider YTD. GE’s credit curve has flattened with
5, 10 and 30 year bonds all trading at a spread of ~300 bps over Treasuries, levels that are more analogous to BB high yield spreads.
The company is in the process of a turnaround plan that includes asset sales for the purpose of de-levering. Other idiosyncratic stories
include tobacco and PCG. For tobacco, spreads widened 37 bps in November on the heels of a proposal by the FDA to ban menthol
cigarettes. While menthol accounts for a significant portion of the U.S. cigarette market (~35%), the process of banning menthol will
be an iterative one and will likely take years to play out. Additionally, tobacco companies have healthy free cash flow and flexibility to cut
dividends if needed. In regards to PCG (+130 wider on the month, 205 wider YTD), and to a lesser extent EIX (+51 MTD, +89 YTD), both
California utilities are exposed to significant liabilities stemming from the recent wildfires. Legislation (SB901) passed in September
established a path for California utilities to socialize some of the liabilities for fires occurring in 2017 (based on a “stress test”) and
2019 and beyond (based on prudency standards). SB901 did not address any catastrophic events that could occur in 2018 as well as the
underlying issue of inverse condemnation, which imposes strict liability regardless of causation. While a legislative remedy could take
time to play out, recent comments from the CPUC and some legislators acknowledge the need to address the wildfire liability issue and
the importance of having solvent, healthy utilities.

November Credit Index Returns

Source: Bloomberg Barclays

BBB vs. Single A Decompression:

The spread of 68 bps is 12 bps wider on the month and 17 bps wider YTD.

New issue concessions ranged from 5 to 30 bps, with deeper discounts prevalent in the latter part of the month as market volatility
increased. Even high quality, lower beta issuers were forced to price with meaningful concessions. For example, four high quality
utility issuers printed deals with an average of 15 bp concessions, including ED (Con Ed) operating co paper at +95 for 10yrs, +135
for 30yrs and Vepco (Virginia Electric Power Co) opco paper at +132 for 30yrs. Utilities tend to issue when they need to fund capex.
Since costs are generally recovered via the rate base, they tend to be less opportunistic about market timing. While the utility space
has historically been lower beta, the sector has not meaningfully outperformed the overall index YTD, even when we exclude the
idiosyncratic names PCG and EIX.